In Michigan Case, Securities Trip Up Foreclosure

Last week, we wrote about how borrowers and courts have uncovered potential defects that could make it harder for banks to foreclose on certain homeowners whose loans were bundled together and sold as securities.

On Monday, a Michigan judge overturned a foreclosure after concluding that the foreclosing entity couldn’t have owned the mortgage after it failed to comply with certain mortgage securitization rules.

In 2006, James Hendricks of Ypsilanti Township, Mich., took out a mortgage from First Franklin, a subprime lender and unit of National City Bank that at the time was being sold to Merrill Lynch & Co. The loan was pooled with others and sold off to investors as securities. U.S. Bank served as the trustee for those investors, and First Franklin foreclosed on the home on behalf of the trust in 2010 after Hendricks defaulted on the loan.

But Jeff Barnes, the lawyer for Hendricks, successfully argued that the trust didn’t have the right to foreclose, in part because it hadn’t been assigned ownership of the loan in accordance with strict rules required to ensure the tax-exempt status of mortgage-bond investments. (Hendricks still lives in the house. Michigan gives borrowers a six-month “redemption period” and Barnes says the foreclosure challenge was filed during that time.)

The decision is a possible setback for the securitization industry, which has argued that its transfers of mortgage loans are valid under the Uniform Commercial Code, which governs commerce across the nation. The Michigan court ruled that the specific securitization agreements didn’t comply with New York trust law, which superseded the UCC because it governs most so-called pooling and servicing agreements. (For more, see this write-up by Naked Capitalism.)

Representatives for U.S. Bank and Bank of America, which acquired Merrill Lynch in 2009, didn’t immediately respond to inquiries.

The court ruled that First Franklin, which originated the loan, was the only entity that could have claimed ownership of the loan. It’s not clear whether First Franklin, which has since been sold, has any interest in foreclosing on a mortgage it didn’t know that it owned. “That’s the rub,” says Barnes. “The ball’s in First Franklin’s court.”

Potentially more troubling is the fact that investors in the mortgage bond deal didn’t actually own the loan that it believed it did. Securitizations are governed by very specific rules to ensure that they wouldn’t run afoul of special IRS rules designed to make mortgage-backed securities investments tax exempt. The case follows a similar decision by an Alabama trial court judge in March.

Mr. Barnes says he plans to use the decision as a “building block” in other cases across the country. “The people who created these securitizations did so according to the regulations of the IRS and the [Securities and Exchange Commission],” says Barnes. “But when they turned around and decided, ‘We’re going to do whatever we want and violate the contracts we created,’ they created this mess.”

Update: A Bank of America representative declined to comment. Bank of America is the mortgage servicer handling the foreclosure. It’s not clear whether Bank of America is also acquired (through its purchase of Merrill Lynch) the First Franklin entity that the court said has standing to foreclose on the Hendricks mortgage. First Franklin was a unit of National City Bank when First Franklin was bought by Merrill Lynch. National City Bank, meanwhile, was later bought by PNC Financial Corp. The upshot is that, depending on which First Franklin entity owned the mortgage, either PNC or Bank of America could be the owner of the mortgage.